This year, GHPIA celebrates its 30th anniversary. Before discussing markets or investments, I want to sincerely thank all our clients for the trust and support you have given us over the years.
Over the past three decades, investors, including GHPIA clients, have lived through no shortage of volatility and uncertainty, including the dot-com bubble, the Global Financial Crisis, and the pandemic. Through each of these periods, we have remained committed to the same core investment philosophy: using disciplined valuation and risk benchmarks to identify attractive risk -adjusted investment opportunities. These benchmarks helped our clients navigate the most volatile market environments of the past 30 years and continue to serve as a cornerstone of our investment approach today.
Today, I want to focus on our equity asset class valuation benchmarks (see Table 1). Since they were first developed by our President and Chief Investment Officer, Brian Friedman, these benchmarks have remained a key part of both our equity allocation and investment selection process and are deeply integrated into our quantitative stock-scoring system. By no means are they absolute or perfect predictors of future returns, nor are they rigid buy or sell rules. However, they help us evaluate the market through a disciplined and consistent framework, allowing us to maintain what we often call our “middle lane” investment approach.
Maintaining a disciplined “middle lane” investment approach over multiple decades also requires recognizing how markets and businesses evolve over time. While our core philosophy has remained consistent, our benchmarks must occasionally adapt when structural changes occur within the market.
After an extensive review, our Investment Committee decided to update our Price to Cash Flow (P/CF) and Price to Book (P/B) valuation benchmarks. These changes reflect the reality that the structure of the market and the underlying economics of many businesses look different today than they did decades ago, and our benchmarks should account for those differences.
Importantly, this review also reinforced that some benchmarks remain highly relevant today, particularly our Price to Earnings (P/E) benchmarks.
One of the key conclusions from our review was that our P/E benchmarks remain appropriate in today’s market and therefore are not changing.
At a basic level, a P/E ratio reflects how much investors are willing to pay for a company’s earnings stream. A company earning $10 per share trading at $200 trades at a 20x P/E multiple. Companies with faster expected growth, more stable operations, and lower perceived risk can generally support higher P/E multiples than slower growing or riskier businesses. For example, our benchmark P/E ratio for Large Cap Growth stocks is 27x earnings versus 23.2x earnings for Small Cap Growth stocks, reflecting the generally higher business risk and uncertainty associated with smaller companies.
Importantly, while markets and business models shifted over time, the core factors that drive P/E ratios remain relatively stable. Interest rates today are still within historically normal ranges. Long term earnings growth expectations and required investor returns also remain relatively consistent versus prior decades. As a result, the relationship between growth, risk, and appropriate P/E multiples has not changed nearly as dramatically as some other valuation metrics.
This is not necessarily true for operating cash flow and book value. As business models, capital requirements, and financial characteristics have shifted over time, these metrics have become less comparable across different periods.
Unlike our P/E benchmarks, our review concluded that our Price to Cash Flow (P/CF) benchmarks should move meaningfully higher across most asset classes.
Operating cash flow is essentially a measure of the cash a business generates from its normal operations. It is an important metric because it focuses more directly on the actual cash being produced by a business.
The relationship between earnings and operating cash flow, however, has changed considerably over the past several decades, particularly in growth-oriented areas of the market. Historically, companies required far more factories, equipment, and physical infrastructure to grow. These assets are depreciated over time for accounting purposes, which lowers reported earnings. However, depreciation is a non-cash expense that gets added back when calculating operating cash flow. As a result, depreciation expense historically represented a much larger portion of operating cash flow than it does for many modern businesses today.
Table 2 highlights this shift. In 1997, median depreciation expense for Large Cap Growth companies represented roughly 39% of operating cash flow. Today that figure has fallen to just 22%, a 17-percentage point decline. Similar trends exist across most asset classes.
When depreciation was a much larger percentage of cash flow, operating cash flow tended to overstate the cash that a business could truly keep because more money would eventually be needed to replace factories, equipment, and other assets. As a result, investors were generally willing to pay less for a dollar of cash flow than for a dollar of earnings. Today, depreciation consumes a smaller share of cash flow, making operating cash flow a closer approximation of actual earnings and supporting higher P/CF multiples relative to the past.
This is exactly what our updated benchmarks reflect (see Table 3). For example, our Large Cap Growth P/CF benchmark is increasing from 17.5x to 24.9x. While that may appear like a substantial increase at first glance, it primarily reflects the reality that modern growth businesses are far less capital-intensive than they were decades ago.
Our review also concluded that our Price to Book (P/B) benchmarks need to be updated.
The primary reason for our P/B benchmark changes is similar to what we discussed in the P/CF section. Book value, also called shareholder equity, is the accounting value of a company’s net assets after subtracting liabilities. In simple terms, a company trading at 1x book value means the market values the business at roughly the same value as the net assets recorded on its balance sheet.
The challenge today is that many of the market’s most valuable assets are no longer fully captured on the balance sheet. A factory or piece of equipment is recorded directly as an asset, but internally developed software, brands, customer relationships, proprietary data, and network effects often are not. As a result, book value frequently captures a much smaller portion of the true economic value of many modern businesses than it did decades ago.
Share repurchases have also further reduced reported book values over time. When companies buy back stock, cash leaves the balance sheet and shareholder equity declines, which directly lowers book value. If that cash had instead remained within the business, it would have generally accumulated within retained earnings and increased book value over time.
Combined, these factors have caused shareholder equity to represent a much smaller percentage of overall market value for many modern businesses than it did decades ago. Table 4 illustrates this shift clearly. In 1997, median shareholder equity for Large Cap Growth companies represented roughly 22% of market capitalization. Today that figure has fallen to just 9%. Similar trends can be seen across all large and mid-cap asset classes.
Interestingly, the opposite trend has occurred within small cap stocks. Median shareholder equity as a percentage of market capitalization actually increased for both Small Cap Growth and Small Cap Value companies since 1997. In many ways, this reflects how different today’s small cap universe looks compared to prior decades, including a larger mix of companies with lower profitability and more balance sheet intensive business models. As a result, our P/B benchmarks for small cap stocks are actually moving lower rather than higher (see Table 5).
This highlights an important point: these benchmark changes are not simply broad increases across all asset classes. Instead, they reflect the fact that the underlying economics of different areas of the market look very different today than they did when our original benchmarks were established.
The goal of this review was not to justify higher market valuations or abandon our long-standing investment discipline. Rather, it was to ensure that our valuation benchmarks continue to reflect the realities of today’s market and the evolving economics of modern businesses.
Importantly, the core principles behind our investment process remain unchanged. Valuation still matters. Risk still matters. Long term earnings growth and cash-flow generation still matter. What has changed over time is the structure of the market itself, particularly the rise of more asset-light business models and the increased importance of intangible assets.
We believe these updated benchmarks better align our valuation framework with the modern market while still maintaining the disciplined, objective, and balanced “middle lane” approach that has guided GHPIA for the past 30 years.
GHP Investment Advisors, Inc. Benchmarks are determined using any combination of valuation approaches deemed relevant by GHPIA, including Price to Earnings (P/E), Price to Cash Flow (P/CF), and Price to Book (P/B), and other relevant analyses. Consideration is given to such factors as historical and projected financial growth for the company, profit stability, leverage, the quality of earnings, valuations of comparable companies, the size and scope of the company’s operations, the strengths and weaknesses of the company industry information and assumptions, general economic and market conditions, and other factors deemed relevant. While Benchmarks are based on valuations and assumptions that GHPIA believes are reasonable under the circumstances, actual realized returns on such investments may differ materially and do not take into account any fees or expenses that may be associated with investing in those assets. There is no assurance that the investment objectives and strategies described herein will be achieved or successful. P/E, P/BV, and P/CF data are provided by FactSet.
Investment Insight is published as a service to our clients and other interested parties. This material is not intended to be relied upon as a forecast, research, investment, accounting, legal, or tax advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The views and strategies described may not be suitable for all investors. Individuals should seek advice from their own legal, tax, or investment counsel; the merits and suitability of any investment should be made by the investing individual. References to specific securities, asset classes, and financial markets are for illustrative purposes only. Actual holdings will vary for each client, and there is no guarantee that a particular account or portfolio will hold any or all of the securities listed. Past performance is no guarantee of future results. Investments carry risk and investors should be prepared to lose all or substantially all of their investment.
Top Row L to R: Brad Engle, Mike Sullivan, Sebrina Ivey, Christian Lewton, Jason Kitner
Bottom Row L to R: Carin Wagner, Angela Kennedy Lee, Jenny Merges, Brian Friedman, Deirdre Mcguire, Barbara Terrazas, Reed McCoy
